The last few years have been challenging for commodity returns. Years of big investment led supply to catch up to demand in one market after another. The process started in 2007 with natural gas, followed by base metals in 2011, grains in 2013 and, most recently, oil, with surging supply leading to steep price declines.
While slow global economic growth since the 2008 financial collapse and a deceleration in the Chinese economy have been strong headwinds to all commodity subsector returns, we think that the level and timing of supply growth explain much of the price weakness and, more importantly, why the timing of this price weakness has varied across commodity markets. We believe the speed of the supply response will drive returns over the next one to two years.
Overall, absent a genuine surge in the global economy, 2015 likely won’t see a strong rebound in commodity prices; instead, we could see a year of relatively flat returns.
Oil prices will likely stabilize and even move marginally higher
Oil was the last of the major commodity markets to see prices adjust to a large supply shock as the Arab Spring and Iranian sanctions delayed the day of reckoning. However, oil prices had a stunning decline of 50% during the second half of 2014, the result of weak global demand combined with high non-OPEC production and a change in Saudi Arabia’s willingness to serve as the global swing-supplier (see our December 2014 Viewpoint, “OPEC Post-Mortem: All Eyes on U.S. Shale,” by Greg Sharenow). This has created a surplus of roughly 1 million barrels per day (b/d) in the oil market. For the markets to rebalance, this surplus must be stored for future use, and future production growth rates need to decline. We believe we are near that point, and that oil prices will stabilize and even experience some small recovery over the coming months.
Prices could break lower if storage capacity falls short. But we believe any drop would be brief given that Brent below $50/bbl and Canadian oil in the low $30s are already quite close to cash operating costs, slowing the capital expenditures (capex) required to sustain output. In addition, unlike in 2008–2009, when the market last saw a material surplus, today’s functioning capital markets and low yields should allow for maximized storage utilization.
Longer term, we expect global oil demand to continue to grow at close to 1 million b/d each year. Growth in non-OPEC production, centered in the U.S., will be needed to meet that demand ‒ just not the 1.7 million b/d growth of this past year. The Department of Mineral Resources in North Dakota estimates that prices need to sustain $55/bbl on average at the well head (equating to roughly $65/bbl for WTI) to stabilize production at current levels, which implies current prices are already reducing the outlook for growth by more than 0.25 million b/d relative to last year in just North Dakota. In addition, with the five-year forward price of Brent at just over $70/bbl, the same long-end price seen during the heart of the credit crisis, we believe the forward market is below the marginal cost for too many global oil projects, such as deepwater and Canadian oil sands.
In our view, current prices should allow for supply and demand to come back into alignment by year-end, led by a decline in the growth rate of U.S. output and a modest increase in global demand partly due to lower oil prices. We expect the market will anticipate this tightening as evidence of slowing investment accumulates, which should ease the downward price pressure.
However, there is considerable uncertainty in this outlook for competing reasons. Energy has become the largest sector within the high-yield space due to tremendous debt issuance in recent years to finance the massive growth in shale production. This capital will become scarcer as the markets impose greater discipline and higher financing costs on producers, which in turn could accelerate the reduction in U.S. output growth. On the other hand, we expect downward pressure on costs as drilling expenditures slow and producers drive efficiency gains. The magnitude of this improvement will play an important role in where the long end of the curve settles.
While this outlook should offer some solace for investors that most of the pain is over, we expect the oil market to remain in contango, where front-month futures contracts (i.e., those closer to the current date) are at a discount to longer-dated contracts, due to the oil surplus being put into storage. In other words, the futures curve is already embedding a decent improvement in prices.
One positive for investors going forward is seasonal: Oil prices have historically rallied during the first half of the year. The market has largely overlooked this and other potential positive catalysts – such as growing financial stress in oil-producing nations and the upcoming presidential election in Nigeria – that could destabilize output.
Natural gas faces another year of weak pricing
The 2015 outlook for natural gas is for continued oversupply to weigh on prices. Warmer-than-usual winter weather could cut household demand, which could lead to a more severe price response as power generation might not prove to be the backstop it used to be. Unlike in 2012, when coal-to-gas switching helped balance the market, more of today’s coal generation has already been replaced with natural gas, leaving less capacity to absorb further natural gas surplus.
The outlook improves as the time horizon extends. The outlook for natural gas production associated with shale oil production is considerably lower than before. With natural gas liquids (NGLs) pricing at 15-year lows, the benefits of NGLs as a byproduct of tight oil drilling are all but gone. Growing industrial demand, additional coal plant retirements due to environmental regulations, increasing exports to Mexico and the completion of the first U.S. liquefied natural gas (LNG) export plant at the end of the year could return the natural gas market to some semblance of balance in 2016, particularly should U.S. production growth finally slow. While the forward curve is already pricing in an improvement in natural gas prices, we believe there is upside in 2016 and beyond.
We have a bearish bias on agriculture
Despite a negative year overall, agricultural commodities rallied nearly 20% during the final quarter of 2014. Those gains went mostly unnoticed given the large declines in oil during that time. The rally was largely driven by increased sovereign risk for Russia, a major grain producer. The high correlation between Russian sovereign credit default swap levels and grain prices is similar to what we saw during the unrest in Crimea early in the year. We think there are limits to that relationship at the current level of oil prices, however, given the link between corn and oil prices via ethanol. The recent oil price drop has put pressure on ethanol prices to the point that the spread between end-of-2015 ethanol and corn prices is below breakeven for ethanol producers. If these levels are realized, we expect a reduction in ethanol production, which would reduce demand and prices for corn. As a result, we think today’s low oil prices will eventually pass through to lower corn prices, which, in turn, will generally put pressure on other grain prices as producers switch to higher priced crops.
Lower oil prices also mean lower production costs for grains: Fuel is 10% of the variable cost of producing a grain like corn, and fertilizer is closer to 40%. Given current input prices, the one-year forward corn price is therefore likely 5% over marginal production costs and allows for a decent margin for farmers. As always, a drought can cause an upside surprise, but given current long-range weather models, we view this as unlikely and have a general bearish bias to the agricultural sector, and grains in particular.
Metals prices should stabilize
We divide metals into two major sectors: base metals and precious metals. We see precious metals as more of a currency, with prices moving up and down in response to global real yields. Today, gold prices are broadly consistent with U.S. real yields; however, with real yields globally very low, the Federal Reserve likely to hike rates this year and the U.S. dollar likely to strengthen further, we see some downside risk to gold prices.
In aggregate, the Chinese economic slowdown and the country’s rotation to a more consumer-oriented economy from direct investment have been big headwinds to base metals demand and sentiment. Lower oil prices and the stronger U.S. dollar, particularly against floating emerging market currencies, have also been a distinct negative.
Despite this, the industrial metals index was down only 6.5% in 2014 and was actually higher midyear until oil went materially lower. In our view, this outperformance demonstrates that base metals overall are further along in the supply-adjustment cycle than energy is.
For 2015, we see competing impulses of lower oil prices reducing production costs versus a better U.S. economy and the potential for China to advance infrastructure investment to ensure adequate economic activity. With production growth likely having peaked, we expect metals prices to stabilize this year.
On balance, we are neutral on commodities in 2015
In aggregate, we expect a year of only moderate returns in commodities, with gains in oil offset by declines in other sectors like natural gas, agriculture and precious metals. A stronger dollar and continued low global inflation, both of which have weighed on commodities over the last several months, are likely to remain headwinds for performance in 2015. Still, we continue to view commodities as a good diversifier and a potent inflation hedge in a broader portfolio of stocks and nominal bonds, both of which have a negative inflation beta.